Author: John McHale

The Mechanics of Buybacks

The Sunday Business Post reports the government intends to launch a buyback from Anglo bondholders (available here). 

The government is expected to launch a bond buyback for Anglo Irish Bank in the coming weeks, as part of a restructuring plan agreed with the EU Commission. 

The buyback, which will reduce the bill for taxpayers, will offer some bondholders in the new Anglo asset recovery vehicle the option of a bond, or a term deposit, in the new funding bank at a significant discount.

In the discussion of buybacks, or “negotiating with bondholders”, it sometimes seems to be forgotten that the only way these negotiations succeed is that there is a credible threat that losses will be directly imposed on bondholders.   One particularly strange example was when the Minister for Finance took credit for the earlier round of Anglo subordinated debt buybacks, even though these buybacks only took place because of the lack of credibility of the government’s policy of protecting bondholders.   The main reason the bondholders were willing to accept the buyback must have been the risk of a change of government.  

A good cop, bad cop routine may be going on at the moment, with the opposition parties being quite explicit about their intentions.   The Post reports,

Last week, Fine Gael leader Enda Kenny wrote to the EU competition commission saying there was, in his party’s view, “no sound legal or economic case for the Irish taxpayer to repay bond investors in Anglo Irish Bank following the expiry of the guarantee”.

The letter made it clear that he was referring to those bondholders who invested before the September 2008 guarantee, both subordinated and senior debt holders. 

In considering what the threat point in buyback negotiations should be, I have also been surprised by the lack of curiosity about the details of the proposed Anglo split.   Most commentators have been content to repeat the mantra about the need for certainty on the cost and timing of resolving Anglo.   

It will take some time before these uncertainties can be resolved.  But surely we should be told now exactly how the mechanics of the split will work.   What will be the value of the claim that the funding bank will hold on the recovery bank?   Will this bond be guaranteed?   How will capital be divided between the two entities? 

On the last question, a number of reports make the point that the funding bank will only need light capitalisation given that it won’t be making new loans.   This strikes me as a strange claim.  The main purpose of capital is to protect depositors from losses.   Surely a key objective of the split is to protect depositors so that they are willing to keep their funds in the funding bank, potentially weakening the need for guarantees of deposits or the bond issued by the recovery bank.   On the other hand, if the goal is to encourage the bondholders to accept buybacks, shouldn’t the recovery bank be capitalised as lightly as possible?  Some harder questioning about the mechanics of the split seems warranted. 

Creditworthy?

Donal O’Mahony provides a robust defence of Ireland’s creditworthiness in today’s Irish Times (article here; supporting Davy Research Report here).  Dan O’Brien is more worried.   While it is always worth some pause when second guessing the market’s average judgement, I’m inclined to agree with O’Mahony: I believe Ireland can avoid default, should avoid default, and will avoid default. 

It is a pity he spoils things a bit with the straw man that many politicians and academics are advocating default.

In truth, foreign misrepresentation of the Irish story is being partly fuelled by domestic coverage. Given the clarion calls of many opposition politicians and academics for a default of Irish liabilities as a legitimate policy “solution”, the self-fuelling impression conveyed abroad is one of heightened insolvency risk.

I don’t see this chorus.   Both Fine Gael and Labour were quite explicit this week that Ireland should not default.  Even if the reporting is sometimes confused, the bright line between defaulting on sovereign debt/guarantees and allowing non-guaranteed investors in failed companies to bear losses is now well accepted. 

Politicising the Banks

Peter Mathews has a thought-provoking piece in today’s Irish Times (see here). 

The basic theme is the likelihood of substantial capital holes in both AIB and Bank of Ireland.  The reminder to look beyond Anglo is timely.   But there is one piece of the analysis that I believe is seriously misconceived: 

All of this will result in temporary State nationalisation of these three banks. This leads to another question: where will the €6.5 billion balance come from? The State will be in majority control, at levels in excess of 85 per cent, and able to force existing bondholders in AIB, BoI and EBS to take writedowns on their holdings of bonds, while maybe offering them, say, a small debt-for-equity swap as a sweetener to soften the blow.

Since when did majority control give you the right to force creditors to take writedowns?   The only way to force writedowns is through bankruptcy (or some other yet to be enacted resolution authority).   (Moreover, “voluntary” writedowns only take place when there is a credible threat of the more strong-armed thing.)

I think Peter is right that the State must be willing to generously recapitalise the banks as necessary.   We have seen the consequences of Japanese-style,  under-capitalisation first hand.   But Peter’s casual assumptions about state control reinforce for me the dangers that come with state ownership.   Part of the policy challenge must be to make the banking system safe for political control.   Part of this must be to convince the likes of Minister O’Keeffe and Minister Ryan that the day-to-day control of the banks is not an instrument of government policy.    If we don’t, we could dig a bigger hole than we are in already. 

All in a Day, a Guest Post by Ciaran O’Hagan

Ciaran O’Hagan is head of rates research at Société Générale in Paris

Risk aversion has picked up in Europe over the past weeks. The debate over the fiscal and banking outlooks in Ireland needs to be placed in this context. While Irish credit is under pressure, it is also against a backdrop that favours risk aversion.

The flavour of Wednesday’s press alone gives a good idea of the headwinds facing any country wanting to grow itself out quickly from public debt. 

The ECB’s chief economist, Mr Stark, is warning of a slowdown in growth,  Meanwhile the Bundesbank’s Weber is cautioning that the global financial crisis is not yet over and setbacks in financial markets cannot be ruled out.  Behind this talk is of course the cautioning of governments that they need to show long-term commitment towards fiscal consolidation, or else brave the consequences.

Unfortunately several governments are non-existent. Belgium’s mediators warn there will be no announcement in relation to a new government this week, and there is no quick progress in the Netherlands either. Italy’s finance minister affirmed that there’s no autumn emergency. In France, the unions are trying to complicate very necessary – if still modest – pension reforms.

Even what should just be simple procedure is becoming problematic. Comments from the ECB, as reported by government sources in Berlin, suggest ongoing frustration with the IMF over how to deal with the challenges posed by Greece. And Eurostat is reported as saying it is frustrated as it can’t get all the Greek documentation on debt that it wants.

Moreover in Brussels, we have the overriding impression of cacophony from the latest Ecofin and Eurogroup meetings. We had the spectacle of head of the Commission, Mr Barroso, calling on the governments to reform. That absence of reform leads to titles in the press Wednesday like “Europe is Acting as Though it Wants to be Left Behind” (the WSJ) and “Realisation has dawned that sovereign credits cannot survive unless banks are recapitalised (the FT).

Even in AAA land, we read titles like “German banks are in reality the Achilles’ heel of the European banking system” (FT). The Bundesbank’s Weber affirmed that higher capital requirements for banks won’t curb economic growth. However even Mr Weber would probably agree that without strong banks, there will be no robust recovery. Unfortunately Europe won’t allow banks fail, and yet at the same time, many governments treat them as taxable cash cows and excuses for a lame recovery.

Last but not least, Mr Lenihan, the Irish finance minister, extended the guarantee for deposits at domestic banks and laid out plans for the dénouement of Anglo. These were necessary actions. However they unfortunately raise the contingent liability for the Irish state still further.

All this is just in a day’s news. It provides an unfortunate backdrop for any country wanting to grow itself out of public debt quickly. Ireland’s growth rate is probably more elastic than most with respect to global prospects. Unfortunately fiscal consolidation elsewhere in Europe over 2011 and beyond faces strong headwinds. That is helping make investors ever more averse to taking on risk, even among sovereigns, traditionally regarded as among the strongest of all credits.

Continue reading “All in a Day, a Guest Post by Ciaran O’Hagan”

The Costs of Default

Panizza, Sturzenegger, and Zettelmeyer’s influential 2009 Journal of Economic Literature survey on the economics of debt and default has been referenced on different threads over the last few days.   The message has been that the costs of sovereign default in terms debt market access and borrowing costs are relatively low.   While I know that those referencing the paper know these findings provide only part of the picture, I am concerned that some blog readers will come away with too strong a conclusion. 

The puzzle of sovereign debt markets is that they should only be possible if there are costs to default – and especially to voluntary default.   In contrast to corporate borrowers, legal sanctions do not provide much of a deterrent for sovereign governments.   The traditional explanation has instead focused on the value of reputation and thus on future access.   But the finding of low direct capital market punishments for defaulters has put that explanation in doubt. 

Yet sovereign debt markets are alive and well.   From this we can infer that there must be costs of some sort.   Recent attention has focused on domestic costs, such as the costs of severe output losses that have accompanied a number of recent debt crises. 

Here is what Panizza et al. (cautiously) conclude:

If anything, defaults appear to be deterred by the domestic “collateral damage” that tends to accompany debt crises, rather than punishments from outside.   While it is very difficult to empirically disentangle the causes and effects of defaults, there is at least some evidence supporting the idea that defaults may magnify the output drops observed during debt crises.   Once output costs in line with this evidence are assumed in parameterized models of sovereign borrowing, the level of sovereign debt that can be sustained in equilibrium rise to more reasonable levels compared to models in capital market penalties are the only punishment. 

One interesting possibility is that in a world with uncertainty about government/country type, revealing yourself as “non-honest” can have implications for broader dealings both domestically and internationally. 

Even if we take a strict cost-benefit perspective, we should approach “default” cautiously – whether it is debt restructuring or the revocation of guarantees.